2017 Tax Reform: What You Need to Know

Tax Cuts and Jobs Act of 2017: Your Primer

Expanded Standard Deduction, No More Personal Exemption

For those of us who only look at the taxes once a year, terminology can be confusing. Let’s start with a quick review.

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A standard deduction reduces your taxable income. The higher your deduction, the lower is the baseline of taxable income on which you have to pay taxes. The permitted deduction amount depends on your filing status. The old limits were $6,350 for an individual and $12,700 for a couple filing joint. Under the new law, the amounts are higher ($12,000 for an individual and $24,000 for a married couple).

Exemptions reduce your taxable income in a manner similar to deductions. In the past, every person received one personal exemption ($4,050) in addition to the standard deduction. Under the new tax law, personal exemptions have been eliminated.

So, we have a higher standard deduction and no more personal exemption. Is that a good thing or a bad thing? The answer will depend on your situation.

  • For example, a couple filing joint with no dependent children will see their overall deduction increase (old math: standard deduction of $12,700 plus two personal exemptions of $4,050 each gets us $20,800, which is lower than the new standard deduction of $24,000). Higher deduction is good.
  • However, a couple with 3 minor kids will see their overall deduction decrease (old math: standard deduction of $12,700 plus five personal exemptions of $4,050 each equal $32,950, which was higher than the new deduction of $24,000). Lower deduction is not so good.

Expanded Child Tax Credit

The expanded Child Tax Credit will help ease some of the pain of the eliminated personal exemptions. Under the new tax law, the Child Tax Credit is increased from $1,000 per child to $2,000. What’s also important is that the income phaseout thresholds have been significantly increased from the current limits of $75,000 per individual tax filer and $110,000 per married couple to $200,000 for individuals and $400,000 for married couples.

In practical terms, this means that many families that were previously unable to take full advantage of the Child Tax Credit will now be able to do so. Keep in mind that this is a tax credit, which means that you get a direct dollar-for-dollar reduction in your tax liability (as opposed to a deduction that reduces your tax expense indirectly by lowering the base upon which the tax is calculated).

Disallowed Roth Recharacterizations

Roth recharacterizations are a bit of an esoteric topic, so we will summarize it here in normal English.

The old tax rules allowed you to convert a traditional pre-tax IRA to a post-tax Roth IRA.  Why would you do this? Some tax payers opted for the conversion to take advantage of their temporarily low income tax rate.  The conversion was taxed when it happened, and after the funds were placed in a Roth IRA they could grow and be later withdrawn tax-free.

Historically, tax payers had a grace period during which they could reconsider the conversation and essentially press “undo”. That is no longer the case. Roth conversions are still allowed, but once the conversion is set in motion there is no going back.

What does this mean for you? You must be certain that the Roth conversion is your best course of action, so talk to your financial planner before you make a change that is now irreversible.

Alternative Minimum Tax (AMT) Limits Raised

Alternative Minimum Tax (or AMT for short) is a parallel universe of taxation that was originally created to curb the use of loopholes. The law requires that tax expense be calculated using the “normal” tax rules and also the AMT rules. Whichever set of rules produced the highest tax was to be followed.

In practice, the AMT rules affected a broad base of taxpayers, and the original intention of tax reform was to eliminate the AMT completely. The final law did not go quite that far, but it did increase the AMT exemption amount to the level where many taxpayers no longer have to worry about triggering it.

Cap on State and Local Income Tax and Property Tax (SALT)

The original proposal for the tax reform would have eliminated the deduction for state and local income tax and property tax completely (recall that a deduction reduces your taxable income). The impact of that change would have been vastly different depending on where the individual or family lives. The final version of the bill allows for a SALT deduction but only up to $10,000 per household.

It is important to note that the $10,000 cap is for all of state, local and property taxes – not $10,000 per tax category. Also, the $10,000 limit is the same for individuals and married couples. To prevent taxpayers from attempting to maximize their 2017 deductions, the law specifically prohibits them from deducting 2018 state taxes that were pre-paid in 2017.

Estate and Gift Tax Exemption Doubled

Another example of the original intention of the bill not exactly matching the execution is the estate and gift tax. While the initial proposal recommended the elimination of the estate tax, the law doubles the amount of the exemption (now at $11.2M for individuals and $22.4M for married couples).

Medical Expense Deduction Increased

While the majority of “miscellaneous” itemized deductions were eliminated, one exception worth noting is the medical expense deduction. Previously, medical expenses that exceeded 10% of Adjusted Gross Income (AGI) were deductible. The new tax law reduces that hurdle down to 7.5% of AGI both proactively (for 2018) and retroactively (for the 2017 tax filing). This change is temporary, and the medical expense deduction will revert back to 10% of AGI after 2018.

In practical term, many taxpayers were historically unable to take advantage of this deduction because of the high AIG hurdle. For example, if your AGI was $70,000, then $70,000*0.010=$7,000 in unreimbursed medical expenses did not count, and only medical expenses in excess of the first $7,000 were deductible. The new rule lowers that threshold to $70,000*0.075=5,250 which means that medical expense deductibility kicks in sooner.

The bottom line is that those with high medical expenses (for example, due to a sudden illness or needing braces for a child), as well as those with a low AGI due to low taxable income in retirement or being out of work for a portion of the year, may be able to benefit from this change.

Frequently Asked Questions

Question: The new tax law was meant to simplify the tax code. Does this mean that I don’t need tax planning?

Actually, the opposite is true. The new tax law introduced a lot of changes, some of them making tax code applications more complex. Between provision sunsetting and future changes on the horizon, there is immense value in forward-looking tax planning and tax strategies.

Question: Will my taxes go up or down for 2017?

There isn’t a way to answer this without looking at the specifics of your situation. Independent think tanks like Tax Foundation and Tax Policy Center have projected that the changes will provide a net benefit to most taxpayers.

Question: What will happen to my paycheck?

That is a great question. Most employers set their payroll systems to follow the old sets of deductions and exemptions to calculate how much they must withhold from each paycheck. There are significant changes to deductions, no more personal exemptions, and a change in tax bracket rates to consider.

If you are concerned about what will happen to your “net” paycheck, talk to your employer. In the short term, it is possible to see paycheck amounts go down, even if the overall tax liability for the year will be lower.

Question: I hear that the tax reform was the most sweeping in decades. Does this mean that I have to change my investments?

As a general rule, in questions of investing and financial planning it is best to not overreact. Personal financial situations and financial markets are complex, and we recommend that you remain focused on your resources and goals. If you have experienced (or anticipate) a 

change in your cash flow or cash needs, or if you have a new or different goal for your money, now is a good time to talk to your financial planner or advisor. If your personal situation is unchanged, it is best to fall back on the strategy that was developed by an experienced professional.

What Should You Do Next?

Financial planning is still a key component of making the most out of your resources and tax rules. If you have a financial plan, ignore the political noise and follow your blueprint. If you don’t have a plan, now is the time.

Remember that investment strategies are built to help you meet your long-term goals. Think of it as a large cruise-ship. Trying to alter course every time you hear a bit of unsettling political or financial news is bound to land you on an iceberg or in some other equally unpleasant location. 

Finally, it is worth pointing out that there are many more provisions in the new tax law, from changes to the Kiddie Tax to how alimony is treated for tax purposes. Addressing each one would turn this article into a weighty volume. If we did not speak to a specific question that you are wondering about, please reach out to our team. Our experts are actively researching the new tax law and creating strategies for clients who are affected (or who could benefit from its provisions).